Investments fall in and out of favour all the time. Right now, the investment vehicle everyone seems to be talking about is the active ETF.

Actively managed ETFs, which aim to beat the market through stock selection or market timing, have certainly been very popular with consumers lately. At the end of September 2024, global assets under management surpassed $1 trillion, signalling a significant transformation in the delivery of investment products to investors.

Data from the ETF research and consultancy firm ETFGI shows this growth reflects a substantial 43% rise from $737.1 billion in AUM at the close of 2023. So far this year, net inflows have reached $240 billion — more than double the $114 billion recorded during the same period last year, according to the ETFGI report.

But just because a certain type of investment happens to be selling well, that automatically doesn’t mean you should buy one too. So what are the pros and cons of active ETFs?

 

Pros and cons of an active ETF

The main advantage of active ETFs is that the fees they charge are lower than those for other actively managed funds. It might not seem like a huge difference — typically around 0.2 – 0.4% — but, over time, paying slightly less means that you, the investor, will keep more money for yourself.

Another benefit is that active ETFs are very liquid and flexible investments. In other words, you can get your money out when you want to — something which investors in the ill-fated Woodford Equity Income fund, for example, will wish they’d been able to.

When you see active ETFs advertised, or fund managers talking about them in the media, the advantage of using them that receives most attention is the potential they provide to outperform the market. Of course, we would all like to beat the market, but the sobering reality is that only a very small proportion of active funds genuinely outperform over the long term.

Over short time periods, there are always active funds with impressive recent track records, and these are usually the funds we tend to read about. But, as ongoing data from Morningstar and S&P Dow Jones Indices show us time and again, most active funds underperform their benchmarks most of the time, and outperformance is generally short-lived.

Numerous academic studies have reached similar conclusions. For example, in a 2010 study called Luck versus Skill in the Cross-Section of Mutual Fund Returns, Nobel laureate Eugene Fama and his long-term collaborator Kenneth French found that only a small fraction of the managers they looked at appeared to achieve returns that were not merely due to luck. Those managers were, however, even fewer in number than would be expected by chance alone.

 

Here today, gone tomorrow?

An important point to bear in mind is that there is always a vast array of funds for investors to choose from, but active funds tend to have a short shelf life. By closing funds which have underperformed, or by merging them with more successful funds, fund management companies are able to give the impression that their stockpickers possess genuine skill.

In other words, if you pick an active ETF today, it may not even exist in, say, five or ten years’ time. Even if it does still exist, the odds are that, on a properly cost-and-risk adjusted basis, it will have underperformed its benchmark.

According to a new report from Morningstar, around 40 percent of active equity ETFs face closure because of poor performance and their inability to generate enough fee revenue to cover basic operating costs.

 

 

Plain vanilla, passive ETFs are best

To clarify, we aren’t saying that ETFs are a bad choice full stop. Far from it. When ETFs were first launched in North America in the 1990s, they were an excellent innovation. In those days, all ETFs were passively managed. So they gave ordinary investors the ability to invest, simply, cheaply and efficiently, and to benefit from broad diversification.

Active ETFs, on the other hand, are a much more recent development. The first one was launched in 2008, and they didn’t take off until several years later.

The good news is that plain vanilla, passive ETFs are still very much available. Indeed, passive ETFs still account for about 90% of ETF assets under management globally. What’s more, passive ETFs are cheaper than active ETFs, which means that, in the long run, investors are likely to receive higher net returns. For many investors, therefore, passive ETFs are a very attractive option.

 

Why are active ETFs so popular?

Why, then, are active ETFs now so popular when passive ETFs are cheaper, more diversified, and more likely to produce higher returns over time?

There are two main reasons. The first is that it suits the fund management industry to sell active ETFs rather than passive ones because they generate higher fees. That’s why they spend so much money promoting them.

The second reason, simply put, is that some investors find passive investing boring. If you like, they enjoy the buzz of having a little gamble on an active fund, even if they know the odds are stacked against them.

The fund management industry recognises this need for excitement and exploits it for its own advantage. As the Bloomberg columnist Matt Levine wrote recently: “The way I think about the ETF industry is that it is the modern source of pizzazz in retail investing. There are lots of trades that retail investors want to do, and/or that someone wants to market to them, and ETFs exist to package those trades into convenient formats.

“The fun, pizzazz trades that people want from their brokers, and that brokers pitch to their customers, get turned into ETFs so that anyone can buy them directly.”

 

Try seeking excitement elsewhere

In conclusion, then, if you want to keep things simple and to maximise your chances of a successful investment outcome, you should stick to passive, or broadly passive, investments. If, on the other hand, it’s fun and pizzazz you’re looking for, actively managed ETFs may be worth considering.

Our strong advice is to avoid active ETFs altogether and look for excitement elsewhere. As Paul Samuelson, another Nobel prize winning economist once said: “(Investing) shouldn’t be exciting. Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”

 

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rockwealth Norwich is an evidence-based and fee-only Financial Planning firm situated in the City of Norwich, Norfolk.

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